24 November 2010

Fiscal dominance, the long-term interest rate and central banks

A paper for the Norges Bank Symposium in honour of Governor Svein Gjedrem “What is a useful central bank?”

Oslo, 18 November 2010

Philip Turner Bank for International Settlements Centralbahnplatz 2 CH-4002 Basel Switzerland E-mail: philip.turner@bis.org

Views expressed are my own, not those of the BIS. I am grateful for the statistical help of Bilyana Bogdanova,

Jakub Demski, Magdalena Erdem, Denis Pêtre, Gert Schnabel and Jhuvesh Sobrun. Clare Batts prepared successive drafts very efficiently. I am indebted to several people for helpful discussions and to those who read and commented on earlier versions of this paper: Bill Allen, Hans Blommestein, Stephen Cecchetti, David Cobham, Tim Congdon, Udaibir Das, Charles Enoch, Joseph Gagnon, Stefan Gerlach, Hans Genberg, David Goldsbrough, Charles Goodhart, Jacob Gyntelberg, Kazumasa Iwata, David Laidler, Robert McCauley, Richhild Moessner, Tim Ng, Kunio Okina, Srichander Ramaswamy, Lars Svensson, Anthony Turner and Graeme Wheeler.

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Introduction

In the post-crisis debate, much has been made of the macroeconomic or financial system

effects of central bank decisions on their policy rate. Yet a more fundamental challenge, and

one with many imponderables (theoretical, empirical and political), may well be the greater

importance for central bank policies of the interest rate on long-term government bonds, the

benchmark risk-free rate for maturity transformation. This may raise some radical questions

both about the virtually exclusive focus on the very short-term policy rate as a policy

objective and the use of short-term paper as the vehicle of market operations.

The main reason for renewed interest in long-term debt markets is that governments need to

finance very large debts and will do all they can to keep borrowing costs low. “Fiscal

dominance” is a convenient catch-word – but large government debts are not necessarily

inflationary. What large debts will do, however, is to bring to centre stage the macroeconomic

and financial consequences of government debt management policies. As Goodhart (2010)

argues, these policies will no longer be regarded as the exclusive domain of debt managers

constrained by technical benchmarks largely unrelated to macroeconomic circumstances.

The problem for central banks is that there is no simple way to draw the line between

government debt management policies that respond to macroeconomic developments and

central bank purchases of long-term government bonds in the guise of

balance-sheet-augmented monetary policy. If central banks were to refuse to conduct such

operations, governments could achieve the exact equivalent by issuing short-term bills and

retiring long-term bonds.

But several major central banks over the past few years have indeed demonstrated their skill

and ability in lowering long-term rates. The crisis led them into balance-sheet-augmented

monetary policy. Faced with near-zero policy rates, and an impaired transmission

mechanism, they could no longer concentrate policy action only on guiding the overnight

rate.1 Several central banks have bought government bonds with the explicit aim of bringing

down long-term interest rates (and in some cases narrowing credit spreads on private sector

paper).2 Central bank operations in long-term markets are not new. The central bank’s

1 Many of these operations were limited to short-term interbank markets, and were designed to counter money

market dysfunctions – not the subject of this paper. Nor does this paper address the important issue of how these policies change the balance sheet of the banking system and so influence their lending decisions.

2 The main exception to this has been the European Central Bank which does not have a single government in front of it. Pisani-Ferry and Posen (2010) argue that this institutional fact will create increased transatlantic monetary policy divergence. The absence of a central fiscal authority and the very different budgetary positions of the members of the euro area limits how far the ECB can purchase government bonds even in the secondary market. Its asset purchase programmes (covered bonds in 2009 and sovereign bonds in 2010)

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influence on long-term rates (usually the yield on government bonds) was a prominent

element in earlier debates about what central banks should do and how monetary policy

works. For Keynes, Meade, Tobin and many others, the long-term rate was much more

important than the Treasury bill rate.

The general point is that central banks can operate in many markets other than that for

short-term bills – the foreign exchange market, the government bond market, the equity

markets, derivatives markets etc. Hence monetary impulses can in principle take many

forms.3 The choice of impulse will depend on circumstances, and the policy challenge will be

to assess and contain unintended consequences of “unorthodox” interventions.

Among possible unintended consequences central banks will have to be aware of possible

implications for financial stability. The long-term interest rate on government bonds – indeed

the risk-free yield curve more generally – defines the terms of maturity transformation in an

economy. It can influence risk exposures taken by the financial industry. And it is long-term

rates – not short-term rates – that help determine asset prices.

In short, the high level of government debt in major countries will have implications for

monetary policy, debt management policy and financial stability policies. The links between

these policies are many and complex. They are also likely to take quite different forms as a

direct result of huge government debt. This is what Graph 1 represents. The thesis is that a

long period of high government debt and the associated uncertainty about interest rates

could call into question three widely-held assumptions about economic policy:

Central banks should not operate in markets for long-dated government debt, but should limit their operations to the bills market.

Government debt management policies should be guided by cost-minimisation mandates and not by macroeconomic developments.

The private sector can be relied upon to provide the right pricing for maturity transformation.

These assumptions had much to recommend them in normal times of low official debt and

moderate inflation. They simplified the lives of policymakers in central banks, in debt

management offices and in financial regulation. They allowed different institutions to be held

accountable for distinct mandates. And they provided some insulation from short-term

political pressures. Yet countries with huge budget deficits are not in normal times.

were limited in size and sterilised so as to have no impact on the money supply. In addition, many members regard the central bank purchase of government bonds as inherently compromising the independence of monetary policy: the ECB acts as a guarantor against fiscal dominance.

3 As Meltzer (1995) concluded in the Journal of Economic Perspectives symposium 15 years ago, the monetary insight is that “monetary impulses set off a transmission process that changes many relative prices and real variables until neutrality is (eventually) restored”.

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It must be acknowledged at the start that there is no well-defined anchor for any policy

attempt to influence the long-term interest rate. In principle, the “normal” level of long-term

interest rates is determined by fundamental saving and investment propensities. In practice,

however, we lack a reliable benchmark. Klovland (2004) suggests that the answer for

Norway is a real long-term interest rate of a little over 4%. Hicks (1958) found that over

200 years the yield on consols tended to settle in the 3–3½ range. But we do not know how

the rise of rapidly-growing and high-saving countries has altered this equilibrium. Until the

early 2000s, the real long-term interest rate – as measured by index-linked securities –

remained close to these historical norms (see the green line in Graph 2). But from 2003 it

began to fall, and Federal Reserve increases in the policy rate from 2005 to 2007 did not

stop this. Current real yields for 10-year bonds are between 0 and 1%. This could be just a

temporary blip. But the fact that even the 5-year five-years forward rate is at around 1½%

suggests the market expects that interest rates could be extremely low for many years. But

we do not know.

The plan of the paper is as follows. Section 1 argues that very high government debt/GDP

ratios will make the short-term/long-term mix of government debt an instrument of

macroeconomic policy. Section 2 argues that this will also have implications for financial

stability policy because the long-term interest rate on government bonds is fundamental for

maturity transformation. It defines a convenient discount rate to apply to the earnings of all

assets, and so influences all asset prices. But official influence on the long-term rate has

grown in so many ways that it cannot be regarded as a pure market rate. Section 3 explains

the lack of any simple logical demarcation between government debt management policies

and monetary policy. A simple and exclusive central bank focus on the overnight rate, with

operations only in short-term markets, conveniently created in recent years a practical

demarcation of operational responsibilities. Yet in the not-so-distant past a focus on central

bank purchases or sales of government bonds (or the equivalent debt management

operations) to influence long-term interest rates had been seen as important tools of policy in

many different situations. In the United Kingdom, for instance, Keynes argued in favour of

large-scale purchases in the 1930s. Official finance in the postwar period incorporated an

almost-explicit target for the long-term rate. The Radcliffe Report in the late 1950s argued

that central banks could make a policy of monetary restriction more effective more quickly by

selling government bonds. The monetary-aggregate-centred policies in the late 1970s

required substantial sales of long-term government debt. Section 4 argues that the mandates

of government debt managers usually mean that their actions are endogenous to

macroeconomic and monetary developments. Large public debts will refocus thinking on the

general question of monetary transmission mechanisms related to the supply and demand

for assets other than short-term bills. Section 5 considers the transmission channels of

policies to change the duration of government debt in the hands of the public. Section 6

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examines recent Quantitative Easing (QE) from the perspective of the consolidated balance

sheet of government and central bank. The current direction of US Treasury issuance runs

counter to the policy intention of QE – as it did in the similar Operation Twist operation in the

1960s.

1. New fiscal dominance?

Large and persistent budget deficits in the advanced economies have led to a substantial

increase in government debt. According to BIS estimates, government bonds outstanding

amounted to over $37 trillion at June 2010, compared with $14.4 trillion at the start of the

2000s (Table 1).

There is huge uncertainty about future fiscal prospects. Economists disagree about how

quickly deficits should be reduced: some would stress deflation risks and others inflation

risks. Even if economists were to agree, there would still be great uncertainty about political

choices on budgetary policy. We just do not know how quickly governments will cut deficits.

It is nevertheless certain that government debt/GDP ratios in major countries will continue to

rise over the next few years. Even the optimistic G20 pronouncements do not envisage

debt/GDP ratios in the advanced countries stabilising before 2016. Graph 3 shows

projections for the United Kingdom: according to estimates prepared before the recent

election, the debt will rise to about 100% of GDP by 2013. This is well below the post-WW II

peak but still represents a major shift. And the future fiscal costs of interest payments are

likely to be large.

In a simple world of full Ricardian Equivalence, households increase their savings by the

present value of future taxes needed to repay government debt. Their desired bond holdings

thus rise by the exact increase in government debt issuance. Private consumption declines

to offset the increase in public expenditure, leaving GDP unchanged. The long-term interest

rate therefore remains constant. But this paper assumes a non-Ricardian world so that

changes in debt/GDP ratios can have major macroeconomic consequences.4

The specific question of how far high government debt could constrain the ability of the

central banks to set the policy rate to control inflation has been much debated. One extreme

is the “fiscal dominance” view. Heavily debted governments force the central bank to accept

inflation in order to reduce the real value of their debt. In the case of the United Kingdom, the

4 See Woodford (2000). He argues that a Ricardian government – which he defines as one that reduces its

deficit in response to a rise in the debt/GDP ratio – can limit the impact on long-term rates of large government debt.

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unexpectedly sharp rise in inflation in the late 1960s and early 1970s reduced debt/GDP

ratios significantly. The other extreme is “monetary dominance”. Central banks raise interest

rates to avoid the inflationary effects of excessive budget deficits. Interest rates rise across

the maturity spectrum and the prospect of higher-and-higher debt service costs then forces

governments to reduce their primary deficits. This seems to fit the UK story in the late 1980s

and early 1990s when tighter macroeconomic policies (monetary and fiscal) brought down

inflation. But it took some time for this policy stance to earn credibility and reduce long-term

interest rates.

Many crises in developing countries in earlier decades support the fiscal dominance story.

This was mainly because governments in such countries did not have the option of financing

budget deficits with long-term bonds issued in local currencies and sold to the non-bank

domestic private sector. They could not borrow long term because their macroeconomic

policy frameworks lacked credibility. They had little option but to borrow from the banking

system or from abroad. These borrowing constraints made the monetary accommodation of

significant fiscal deficits almost inevitable. The interaction of domestic bank credit expansion

with devaluation spirals served to reinforce fiscal dominance.5

In advanced economies, however, governments have many ways to finance large deficits in

non-monetary ways. Issuing marketable government debt of various maturities to the private

sector is the textbook financing choice. Hence any fiscal dominance story is more complex

than in developing countries. Any analysis of how far very high government debt will

constrain monetary policy choices will therefore have to address the debt financing choices

of government and their consequences.

There is no simple link between government debt/GDP ratios and the long-term interest rate

on government bonds. Other things equal, higher debt ratios coming from increased

structural fiscal deficits (ie beyond the cyclical element) should imply higher real long-term

rates as governments bid up the cost of borrowing.6

The qualification “going beyond the cyclical element” is important. Fiscal deficits arising from

allowing the automatic stabilisers to work should have no influence on long-term interest

rates. Furthermore, the policy choice of increasing structural budget deficits for a specific

period as a deliberate response to weak private investment demand need not raise long-term

rates. Indeed current borrowing demands of the private sector (companies and households)

5 One classic reference is Rodriguez (1978). BIS (2003) shows how fiscal dominance was reduced in many

EMEs by major reforms. See also Buiter (2010) for an application to the recent euro area crisis. 6 At least in a closed economy. A small country whose credit standing is not in question will be able to borrow

abroad at the risk-free international rate. In such circumstances, the relevant variable is not its own debt ratio but some measure of the global fiscal position.

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have been greatly weakened by the crisis. Because the credit-creating capacity of the

banking system will be constrained by the needs for banks to deleverage and because

households need to repair their own balance sheets, near-term prospects for private

investment demand are not strong. Inflation expectations are well contained. Hence real

long-term yields on government debt in major countries are at present very low.

A second, and more fundamental, qualification is that long-term interest rates depend on

market expectations of future debt/GDP ratios and of future monetary policy – and not

directly on current policy settings. If the commitments of government to limit the rise of

debt/GDP ratios and of central banks to prevent inflation are fully credible, long-term interest

rates need not rise.

Current market expectations of future fiscal policies are probably still conditioned by the

credibility governments in most advanced countries earnt from successful fiscal consolidation

during the 1980s and the 1990s. Those policies took many years to convince markets and

bring down long-term interest rates (see panel C of Graph 3). The commitment to lower

budget deficits and to adopt a tighter monetary policy regime were not fully credible for some

time. Nominal long-term interest rates on government debt therefore remained high for many

years.7 Even if mean inflation expectations remain low, uncertainty about fiscal prospects

may itself widen the risk premium in long-term rates.

Because of extreme monetary ease, short-term interest rates have been close to zero for

some time and markets expect rates to remain low. The yield curve is (as of September

2010) still quite steep. This interest rate configuration has major consequences for financial

intermediaries. An upward sloping yield curve provides an attractive running yield for banks

which typically borrow short and lend long. At the same time, those who have invested in

government bonds face interest rate risks that increase with the lower yields. The sharp

decline in Japanese government bonds in 2003 illustrates just how suddenly such risks can

materialise (Box 1).

The direct fiscal effects of changes in budget deficits (ie flow effects on income) have a quick

but temporary impact on aggregate demand – at least according to the standard

income-expenditure models. But the financial and monetary effects of the increased stock of

government debt that results from these deficits (ie stock effects from changes in balance

sheets) are permanent. Public debt affects both the size and the composition of private

sector balance sheets. Expectations of how such effects will work can bring forward the

7 King (1995) called this mechanism “some unpleasant fiscal arithmetic”. Monetary policy restraint for a time

actually increases government borrowing costs: a successful policy of disinflation does not reduce nominal long-term rates immediately because expected inflation declines much more slowly than actual inflation.

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ultimate impact. And volatile expectations about these effects can themselves be a source of

instability. Such effects have many dimensions.8

Box 1 The 2003 crisis in Japanese government bonds

The market dynamics behind the sharp jump in yields on JGBs in mid-2003 provides an interesting illustration. From late-2002 to mid-2003, regular investments by banks and institutional investors in JGBs led to a steady decline in yields, with the 10-year interest rate reaching about ½% in June (see Graph 4). Regulatory requirements forcing banks to reduce their holdings of equities and weak lending demand also reinforced banks’ demand for JGBs.

According to Nakayama et al (2004), the BoJ’s QE commitment in March 2001 to keep policy rates very low until the CPI had registered a year-on-year rise in the CPI led market participants to expect low rates to be maintained for an extended period. The yield curve therefore flattened and bond market volatility declined. With risk tolerance levels given (and the risk measured by volatility observed in the recent past), lower volatility allowed banks to increase their holdings of JGBs. Thus the decline in market volatility reinforced downward pressures on the yield.

The long-term rate overshot in a downward direction. Once concerns about deflation risks abated, expected future short-term rates rose. As markets began to expect an earlier end to monetary policy easing, volatility rose. This rise in the volatility of interest rates served to further reduce the demand for bonds and thus magnify the rise in the interest rate. Because the banks were all using the same historical volatilities to assess risks, they were all led to try to reduce their interest rate exposures at the same time. The net result was a sharp rise in yields which imposed significant losses on the banks.

The dimension that is most relevant for this paper is the macroeconomic consequences of

the short-term/long-term mix of outstanding debt. This depends on whether investors regard

short-term and long-term paper as close substitutes. In a world of perfect certainty about

future short-term rates, the maturity mix of debt would have no consequences because debt

of different terms would be perfect substitutes for one another. A high degree of asset

substitutability would also support the pre-crisis monetary policy orthodoxy that control of the

overnight interest rate is sufficient for central banks to shape macroeconomic developments.

Changes in the overnight rate (and expected future overnight rates) feed through quickly to

at least the near end of the yield curve. Transmission of policy rate changes to the whole

structure of interest rates is thus effective.

In practice, however, uncertainty about the path of future interest rates (and differences in

investor preferences) will make debt securities of different maturities imperfect substitutes.

Because of this, changes in the mix of short-term and long-term bonds offered by the

government will change relative prices and thus influence the shape of the yield curve. At the

8 One dimension is size effects. Whether higher government debt increases perceived private sector wealth

depends on how far the private sector regards the wealth it holds in government bonds as diminished by the present value of the future taxes that are required to service the debt (the Ricardian equivalence point). Another dimension is the asset side of government balance sheets: funding growth-promoting investment is quite different from financing current consumption.

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same time, monetary policy based on setting the policy rate becomes less effective: the

lower the degree of asset substitutability, the weaker the transmission of changes in the

overnight rate to other interest rates. Hence debt management policies (or

balance-sheet-augmented monetary policy) become more effective in conditions when

classic monetary policy works less well.

Furthermore, debt management policies can be all the more effective in the special case of

the zero lower bound (ZLB). This is because policies aimed at shortening the duration of debt

held by the public (ie selling Treasury bills and buying government bonds) may lower

long-term yields without raising short-term yields, which are glued close to zero at the ZLB.

But note that the corollary of the ZLB argument on its own is a policy asymmetry. Central

banks may need to buy government bonds when at the ZLB if they want to stimulate

demand. But they have no need to sell government bonds when they want policy to be

restrictive – because all they have to do is raise the policy rate.

However, the conclusion about the effectiveness of debt management policies based on

asset substitutability is much broader and more symmetric than the special ZLB case. Even

in normal circumstances, when the policy rate is above zero, policy can be made to work

more surely and more rapidly by acting in longer-dated markets. It therefore applies to

policies of monetary restriction as much as to policies of monetary ease. The fall in bond

yields in the early phase of Federal Reserve tightening in 2004–05 (the famous “conundrum”

of Greenspan9), which weakened the restrictive impact of higher policy rates, could have

been countered by longer duration debt issuance or by Federal Reserve sales of long-term

bonds. How effective this would have been depends on the degree of asset substitutability.10

It could be argued that a prevailing sense of interest rate predictability at that time and a

banking system willing to take huge duration exposures would have made such a policy

ineffective. This remains an open question. (As it was, the 2000–4 period was one when the

maturity of US Federal debt shortened significantly adding further stimulus – see below).

There is no reason to expect the degree of substitutability between assets of different

maturities to be constant over time.11 In addition to uncertainty about future interest rates, the

9 See chapter 20 of Greenspan (2007) for an account of this. He says that low long-term interest rates reflected

real economy saving and investment propensities globally. He does not address the question whether Federal Reserve sales of government bonds could have driven long-term yields higher.

10 Hamilton and Wu (2010) consider a converse operation. They estimate that if the Federal Reserve had, in December 2006, sold all its holdings of short-term Treasury bills ($400 billion at that time) and used the proceeds to buy long-term bonds, this might have resulted in a 14 basis point drop in the 10-year yield and an 11 basis point increase in the six month rate.

11 Agell and Persson (1992) argue that asset substitutabilities and the associated risk premia reflect the subjective risk perceptions of investors and so will not be stable over time. Historical return-covariance matrices miss “news” affecting market fundamentals. Their empirical work supports these concerns: they are therefore very sceptical about the scope for debt management policy to affect yields in a predictable way.

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ability of financial intermediaries to take duration exposures will also be an important

determinant.12 Both determinants are likely to change over the cycle. In a crisis, in particular,

asset substitutability will fall not only because uncertainty about future interest rates rises but

also because banks and others will be less able to undertake interest rate arbitrage

operations. Indeed, impaired bank arbitrage capacity was one important justification for the

exceptional balance sheet policies central banks followed in this crisis. Large fiscal deficits

will also increase interest rate uncertainty, and therefore lower the substitutability between

short- and long-dated debt securities.

A further complication is that Goodhart’s Law will eventually apply to debt operations.13 The

central bank may virtually fix the yield of its target bond. But if central bank action is known to

have concentrated on a particular maturity, then its information content is compromised.

Investors may judge that such paper is overpriced relative to paper of other maturities, and

therefore avoid buying it. In time, private sector contracts might avoid referencing an interest

rate regarded as manipulated by the authorities.

Nor is there any reason to suppose that the degree of asset substitutability will be constant

across countries. In particular, it is likely to be lower in smaller or less developed financial

markets. Hence the central bank in such countries is more likely to intervene directly in

several market segments.14

Changes in the yield curve will affect spending decisions. Holders of long-term debt will have

capital gains or losses. In addition, increased holdings of government debt by banks can

influence credit creation mechanisms and so have different implications for aggregate

demand (and for the economy’s response to financial shocks) than if such debt were held

outside the banking system. It will also influence interest rate exposures in private sector

portfolios. The exposures of financial intermediaries could have implications for systemic

financial stability and are thus of potential interest to central banks.

12 Other important determinants are: initial conditions (eg closeness of the long-term rate to its lower bound); the

mandates given asset managers (eg value preservation versus fixing future income streams); accounting rules; and the regulation of financial firms. Changes in yields will also influence income flows to bond holders and lead to capital gains or losses. How banks, pension funds and other investors respond to such incoming effects will also be important – and very difficult to foresee. None of these elements is well understood.

13 Goodhart’s Law is “Any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes”.

14 On this see Filardo and Genberg (2010) and chapter H of BIS (2009). Actions to stabilise government debt markets (eg sharp shortening of duration of new debt issuance, facilities to allow bond holders to swap long-term fixed interest rates with short-term variable rates, relaxation of mark-to-market accounting rules) were prominent in several EMEs during the 2008 crisis.

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2. Maturity transformation and financial stability

Michael Bordo and Lars Svensson argued persuasively in this conference that the short-term

interest rate is important for macroeconomic stability but is not a central element in financial

stability.15 The long-term interest rate on government bonds, however, must be of

significance for systemic stability because it defines the shape of the yield curve and serves

as a fundamental benchmark for the pricing of assets generally. And the “search for yield”

story is more plausible when long, rather than short, rates are very low. There are thus

strong grounds for supposing that the yield curve on government paper could have

implications for macroprudential policies – now the responsibility of central banks in many

countries. The difficulty is that it is not clear which elements are likely to be most important in

practice. Nor is it clear how these elements may interact.

There are at least three reasons why the shape of the risk-free yield curve (almost always

that based on government paper) plays a key role in determining the risk exposures taken by

the financial industry.

The steepness of the yield curve determines current returns (ie ignoring capital gains and losses) from borrowing short and lending long. It also affects the incentives of banks to lengthen the duration of their liabilities.

The level of long-term rates influences all asset prices by providing the discount rate to value the expected earnings of such assets. Other things equal, a reduction in the long-term rate, would tend to raise house prices, equity prices and so on.16 Hence the level of long-term rates is central to any analysis of asset prices.

The long-term rate provides the risk-free benchmark for financial firms such as pension funds to fund future long-term liabilities. When long-term rates fall, steady-state pensions decline.17 Funds that cannot cut the pensions they pay may build-up hidden losses. Or they may invest in higher-risk, high return assets. Either way risk exposures could rise.

The conclusion is that the oversight of the financial system stability must weigh several,

distinct implications for aggregate financial exposures of the long-term interest rate.

There are, however, no well-established methods of analysis for assessing – or even

defining – the aggregate interest rate exposures of the financial industry. Maturity

transformation is the core business of the financial industry. Yet there is no easy way to

15 During the decade before the financial crisis there is no evidence that lower policy rates lead to increased

risk-taking in the financial industry. Indeed, credit spreads were lowest after the Federal Reserve had raised the Federal funds rate to 5½%. See Graph 2, page 22 in BIS (2010).

16 At least in the short-run. In general equilibrium, factors such as Tobin’s q, the rental/price ratio and so on would play an equilibrating role as asset prices diverge from their steady-state values.

17 They will benefit from a one-time rise in the market value of their financial assets – but normally the present discounted value of their liabilities (which typically have a longer duration) would rise more.

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determine the optimal degree of maturity transformation in an economy. Nor is it clear how

much of this banks should do.18

Notwithstanding this theoretical gap, one of the lessons many have taken from the financial

crisis was that the banks were doing too much maturity transformation. In those countries

where bank regulators had virtually abandoned statutory liquidity ratios, investment by banks

in long-term and illiquid assets became too dependent on short-term borrowing. Once the

crisis struck, it was governments and central banks which rescued banks with illiquid balance

sheets. Hence the post-crisis policy prescription is that bank regulators should impose more

demanding liquidity rules, with the aim of getting banks to lengthen the maturity of their

liabilities (or shorten the duration of their assets) and pay greater attention to liquidity risks.

Lowering the rate of interest on government bonds helps banks to issue long-term debt.

Maturity transformation by other financial intermediaries, however, also plays an important

role. Quite the opposite of banks, intermediaries such as pension funds and insurance

companies have (uncertain) long-term liabilities (and assets of a shorter maturity). The

analysis of Tirole (2008) sheds very useful light on this. In the presence of macroeconomic

shocks that affect everybody simultaneously, he argues, private sector assets are not useful.

Instead what is needed is an external risk-free store of value such as government bonds.19 A

prolonged period of low rates of interest on government bonds can make some pension

products offered by such firms unviable. Tirole therefore argues that:

“liquidity premia [on] risk-free assets [is] a useful guide for the issuing of government

securities both [in total] and in structure (choice of maturities) … a very low long rate

signals social gains to issuing long-term Treasury securities. A case in point is the

issuing by HM Treasury of long-term bonds in reaction to the low rates triggered by the

2005 reform of pension funds requirements.”

As will be discussed below, Keynes also advocated “accommodating the preferences of the

public for different maturities”. It was, he argued, socially desirable that widows, orphans,

university endowments and other worthy causes should get some minimum, safe return on

their capital – so that the long-term rate of interest should not go to zero. (Nowadays, the

argument would be in terms of pension and insurance fund assets.)

The question is how to translate the theoretical arguments of Keynes and Tirole into practical

policy on government debt issuance. Keynes’s prescription seems to have been that the

18 Tirole (2008) explains lucidly why current economic models which assume perfect capital markets do not

address the question of liquidity satisfactorily. 19 Echoing Keynes, he writes, “risk-free securities are held not so much for their return, but rather because they

deliver cash when firms need it: they are liquid in the macroeconomic sense.”

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government should gear its issuance policy in part to defining an upward-sloping floor for the

risk-free yield curve. How to do this in present-day terms? To provide the required insulation

from inflation shocks, inflation-linked debt would be best. One possible anchor, then, could

be an elastic supply (tap) of inflation-linked papers of different dates (eg 5-year, 10-year,

consols) with fixed interest rate coupons that rise with the paper’s original maturity.

The issue of how far the public sector should go in defining the terms of maturity

transformation is extremely controversial.20 But the fact is that government policies dominate

the terms of maturity transformation in modern economies. Very large government debt

defines the yield curve. Regulations have a pervasive effect. Many supervisory rules for

financial firms in effect create a near-captive demand of regulated entities for government

paper. In some countries, near-mandatory holdings by regulated financial firms are so large

as to impair the information content of so-called “market” prices. Recent regulatory proposals

(eg Basel III) aimed at encouraging banks to reduce liquidity risks are tantamount, in most

countries, to getting banks to hold more government debt – simply because such debt is

traded in liquid markets, is of low credit risk, and (unlike credit exposures to the private

sector) holds its value during cyclical downturns.21 The influence of government policies is

also felt in many other ways. The terms of mortgage finance are heavily conditioned by state

financing arrangements. Taxation practices are another potent element. The fact is that the

role of government is in fact already very large, and has grown with the crisis. But this role is

quite unconscious. The cumulative impact of the many official policies on the long-term

interest rate needs much more analysis.

When bank holdings of government debt are very large, even monetary policy choices could

be constrained. Substantial holdings of short-term bills could make banks less responsive to

monetary control.22 Holdings of long-term bonds expose them to the risk of capital losses. On

this latter point, Eichengreen and Garber (1990) quote the Federal Reserve in 1945:

“A major consequence … of … increasing the general level of interest rates would be a

fall in the market values of outstanding Government [bonds] … which could have highly

20 In earlier periods, the term structure of interest rates was regulated. In countries where interest rates on bank

deposits were controlled, the regulations usually enforced (irrespective of the cyclical position of the economy) an upward sloping interest rate curve. This rewarded savers who are prepared to give up liquidity and place their funds at longer terms, which made the banks safer.

21 Note, however, that the liquidity rules prevailing up until the mid-1970s generally enjoined banks to hold short-dated paper. For instance, UK banks were required to hold only short-dated government bills to meet their liquid asset ratios … long-dated government bonds did not meet the liquid asset rules.

22 This applies in particular to those forms of monetary control that rely on liquid asset ration. The UK authorities in the post-war authorities kept liquid asset ratios imposed on banks very high because of the large volume of short-term government debt held by banks. Forcing banks to remain very liquid also made them safer – and so served financial stability objectives. On the UK’s experience, see Dow (1965), Chapter IX.

13

unfavourable repercussions on the functioning of financial institutions and … might

even weaken public confidence in such institutions.”

They point out that operations had to be undertaken in the immediate post-war period to

reduce the interest rate exposures of banks before the Federal Reserve could feel

comfortable raising policy rates.

The current macroeconomic configuration is conducive to sizeable interest rate exposures in

the financial industry. Prolonged monetary ease and structural fiscal deficits imply low

short-term interest rates and upward sloping yield curves. Graph 5 charts the term spread in

US dollar markets: there is currently a maturity spread of about 200 basis points (an

attractive “carry”). Volatility in the bond market is rather low. This means that

backward-looking measures the banks use (based on volatility) suggest that the risk of

holding bonds is low. The so-called carry-to-risk ratio is therefore high. This creates

incentives for banks and investors to increase maturity exposures. As just noted, the market

incentives created by a steep yield curve (which in turn reflects macroeconomic policy

choices) run directly counter to recent microprudential policies aimed at getting banks to

lengthen the maturity of their borrowing and hold more liquid assets.

Because virtually all firms are tempted to take the same risks (“herding”), there is also a very

important macroprudential dimension. All firms will not be able to get out when expectations

of future rates change – leading to “overshooting” in market interest rates or even illiquidity in

interest rate hedging markets.

A final financial stability dimension is that the ability of banks and other financial firms to

issue long-term paper is likely to be a major issue in the years ahead. Before the crisis,

yields on bonds issued by financial firms tracked those on government bonds, with a spread

of 100 to 150 basis points (Graph 6). A loss of confidence in banks as a result of the crisis

led to a dramatic rise in spreads. These came down gradually during 2009 only because of

government guarantees. At present, bank yields are over 5% while short-term funding costs

less than 1% – in other words the yield curves facing bank borrowers are much steeper than

those facing governments. Recent issuance trends of financial firms are not encouraging.

Financial institutions’ long-term debt issuance in 2009 about one half what it had been from

2003 to 2008 – despite government guarantees. Net issuance was actually negative in the

first half of 2010 (Table 2).

14

3. Central banks and debt management policies: a brief history

How governments decide to manage the financing of much-increased government debt will

have major monetary and financial implications. There is no simple logical demarcation

between such decisions and monetary policy.

Central banks in effect issue the shortest duration official debt in their operations to

implement monetary policy. Government issuance of short-term debt is like monetary

expansion.23 Tobin (1963) puts this point well:

“There is no neat way to distinguish monetary policy from debt management, [both] the

Federal Reserve and the Treasury … are engaged in debt management in the

broadest sense, and both have powers to influence the whole spectrum of debt. But

monetary policy refers particularly to determination of the supply of demand debt, and

debt management to determination of the amounts in the long and nonmarketable

categories. In between, the quantity of short debt is determined as a residuum.”24

He went on to argue for the use of debt management (ie shifting between short-dated and

long-dated paper) as a countercyclical policy to influence private capital formation, and thus

real output. His conclusion was that:

“The Federal Reserve cannot make rational decisions of monetary policy without

knowing what kind of debt the Treasury intends to issue. The Treasury cannot

rationally determine the maturity structure of the interest-bearing debt without

knowing how much debt the Federal Reserve intends to monetise”.25

The active use of central bank balance sheet policies has given new life to this very old

issue. One aspect Tobin did not address might be noted: a central bank of a monetary area

faces a special challenge because there is only one central bank but many different

governments that decide debt management policy.

There is little new in the theory behind balance-sheet-augmented monetary policy. Open

market operations in long-term government debt were central to Keynes’s analysis in his

Treatise on Money of how central banks could combat slumps. He argued for what he called

“open market operations to the point of saturation”:

23 Rolph (1957) put it this way: “If short-term obligations possess stronger money characteristics than long-term

public debt … shortening the average maturity of government debt becomes an inflationary measure.” 24 King (2004) makes a similar point that central bank purchase of bonds and the government shortening the

maturity of issuance are virtually the same. 25 His suggestion was that full responsibility for Federal government debt management be assigned to the

Federal Reserve, not the US Treasury.

15

“My remedy in the event of the obstinate persistence of a slump would consist,

therefore, in the purchase of securities by the central bank until the long-term market

rate of interest has been brought down to the limiting point.”26

He felt that central banks had “always been too nervous hitherto” about such policies,

perhaps because under the “influence of crude versions of the quantity theory [of money].”27

He repeated this analysis in The General Theory:

“The monetary authority often tends in practice to concentrate upon short-term debts

and to leave the price of long-term debts to be influenced by belated and imperfect

reactions from the price of short-term debts – though … there is no reason why they

need do so.”28

He went on to suggest that the “most important practical improvement which can be made in

technique of monetary management” would be to replace “the single Bank rate for short-term

bills” by “a complex offer by the central bank to buy and sell at stated prices gilt-edged bonds

of all maturities”.29 It is important to remember that Keynes was writing in the 1930s – when

budget deficits were small and governments (obsessively!) Ricardian.

United Kingdom

There was a massive conversion of government debt to a lower coupon in 1932, which

Keynes regarded as a “great achievement” for the Treasury and the Bank of England.

Short-term rates were cut sharply. But his more general advice for aggressive central bank

purchases of debt (or the equivalent change in issuance) went unheeded. Government debt

remained long term: in the mid-1930s, only 3% of bonds had a maturity of less than five

years and 86% of bonds had a maturity in excess of 15 years.30 Nevertheless, thanks largely

to debt conversion, long-term rates during the 1930s declined from 4½% to below 3%.

During World War II, low interest rates then became a key ingredient of wartime finance. In

the closing months of World War II, with the UK facing huge government debts, Keynes, an

influential member (with Meade and Robbins) in the UK Treasury’s National Debt Enquiry

26 Keynes (1930), pp 331–2. One constraint he saw was that a central bank acting alone would simply induce

capital outflows: he felt the newly established BIS could encourage internationally coordinated central bank efforts to reduce long-term interest rates. Per Jacobsson, Economic Adviser at the BIS at the time, also strongly supported policies aimed at reducing long-term rates.

27 As Congdon (2007) notes, Keynes maintained this emphasis in The General Theory: “There are dozens of statements in The General Theory and other works by Keynes in which he criticised an exclusive focus on the short-term rate in the money market and urged the much greater importance of the long-term rates set in the bond market”.

28 Keynes (1936), pp 206. 29 Congdon (2010) draws attention to this discussion. 30 Quoted from the Radcliffe Report by Capie (2010), pp 304. Other figures cited below are also from Capie.

16

(NDE), argued against the “dogma” of financing debt at long maturities. Governments should

not “fetter themselves … to a counter-liquidity preference” but should accommodate the

preferences of the public for different maturities. He recommended that:

“Interest rates [at] different maturities should … pay attention primarily to (a) social

considerations in a wide sense; (b) the effects of Government policy on the market for

borrowing by the private sector and the problem of controlling the desired rate of

investment; and (c) to the burden of interest charges on the Exchequer.”31

The upshot of the NDE was that the policy of “cheap money”, which began in the 1930s

depression, would be reinforced post-war. Money market rates were reduced to ½% and a

target of 2½% was set for the long-term rate. The reservations of the Bank of England were

discretely muffled.32 Meade dismissed the argument that this monetary policy would lead to

excessive liquidity:

“… I tried hard to persuade Lucius Thomson-McCausland of the Bank of England

that the correct criterion for an expansionist or restrictionist monetary policy was

whether the total national expenditure was showing signs of declining or rising too

rapidly. Beneath a general stability of the total national expenditure one could let

private enterprise go ahead on its own … even though particular firms … would from

time to time burn their fingers. But Lucius persists in thinking in terms of pools of what

he calls ‘flabby’ money which rushes from commodity to commodity causing

speculative booms and slumps, undermining confidence and thus leading to a general

slump. He wishes to drain away such stagnant pools, keeping money what he calls

‘taut’. But the danger is, of course, that the general process of keeping money ‘taut’ will

maintain the rate of interest at an unduly high level so that there is a more or less

permanent deficiency of total national expenditure.”33

It is striking how well all this conversation over lunch in May 1945 foreshadows later

discussions about monetary policy and speculative bubbles.

According to Meade (1990), Keynes argued in the committee that it was “socially desirable”

that rentiers should get some return on their capital – and so the long-term interest rate

31 Keynes (1945), pp 396–7. James Meade’s diary provides an entertaining account of Keynes’s dealings with

Permanent Secretaries during the meetings of the National Debt Enquiry: “perverse, brilliant and wayward” Keynes, “who on the rate of interest was revolutionary in thought but very cautious in policy”.

32 See Fforde (1992) pp 335–337. Niemeyer’s criticism of the Report of the National Debt Enquiry in 1945 was that “… [it] has not looked at all at the actual structure and market standing of existing medium and long-term debt … the argument that continuous borrowing gives the borrower command of the market can only be true if the borrower is able and willing to inflate.”

33 Meade (1990), pp 74.

17

should not go to zero.34 Note that he listed controlling investment before limiting government

debt serving charges.

In the years that followed the immediate post-war period, the policy objective became one of

holding long-term interest rates down even as growth and investment strengthened. This

shift in emphasis impeded effective monetary control. By 1952, the percentage of bonds with

a maturity of 15 years or more had fallen to 63%. During the 1950s, this proportion was to fall

further, prompting the Radcliffe Report to describe the huge supply of short-dated bonds as

“a constant source of embarrassment to the authorities”. The aim of maintaining stability in

the bond market – not macroeconomic control – had become paramount for the central bank.

HM Treasury, in its evidence to Radcliffe, was quite clear:

“No attempt is made to use official purchases and sales in the market for the specific

purpose of raising or lowering the level of medium and long-term interest rates. The

suggestion has been made that sales of longer-dated securities would be increased if

they were offered at prices below the market. In theory, this might be possible for a

time. In practice, such operations would create market uncertainty and so impair the

prospects of continuing official sales of securities … Such operations would involve a

serious risk of damage to confidence and to the Government’s credit.”35

Many of the economists who gave evidence to Radcliffe disagreed with this view. Several

argued that a main effect of monetary policy on aggregate demand worked through the

long-term interest rate. Richard Kahn (1960) reiterated the view that both Keynes and Meade

had expressed in the NDE, namely that the:

“authorities … including the Bank of England … and those responsible for managing the

national debt … are capable, within very broad limits, of achieving any desired structure

of interest rates … provided they are not worried about the quantity of money.”36

Paish provided very interesting graphical evidence that between 1919 and 1958 there was a

clear inverse relationship between the bank deposits/national income ratio (ie the sensitive

part of “money”) and the long-term interest rate37: Paish thus argued that “money” influenced

34 Meade, who believed that investment was more interest rate sensitive than Keynes did, disagreed. His view

was that the long-term rate of interest could be reduced to near zero to counter depression but should rise to meet any inflationary threat. His diary entry for 26 February 1945 reads: “in my mind the real social revolution is to be brought about by the most radical reduction in interest rates which is necessary to prevent general deflation”. See Meade (1990), pp 46.

35 Radcliffe (1960) Memoranda of Evidence, pp 107–8. 36 Radcliffe (1960), Minutes of Evidence, pp 743. Papers submitted by Paish, Johnson, Kahn and Robbins are

particularly interesting on this issue. 37 Notes in circulation showed no such relationship. See Paish (1960), chart I. Laidler (1989), who described the

Radcliffe Report as representing the high tide of Keynesian influence on monetary theory and policy in Britain,

18

aggregate demand via the long-term interest rate. Harry Johnson argued that the Bank of

England’s technique of monetary control based on Bank rate made effective by open market

operations in bills was not very effective. He therefore suggested that open market

operations in bonds, not bills, should become the main weapon of monetary policy.

The key conclusion of the Radcliffe Report was that “the structure of interest rates rather

than the supply of money [was] the centre piece of the monetary mechanism.” In this,

government debt management was to play a central role. The Report concluded with five

main points. Among them a clear – and all-too-often overlooked – statement of the

importance of the long-term interest rate as an objective of monetary policy.

“There is no doubt that … monetary policy … can … influence the structure of interest

rates through the management of the National Debt which, if burdensome to the

financial authorities in other respects [ie increasing debt servicing costs], affords in this

respect an instrument of single potency. In our view debt management has become the

fundamental domestic task of the central bank. It is not open to the monetary authorities

to be neutral in their handling of this task. They must have and must consciously

exercise a positive policy about interest rates, long as well as short.38

The Report argued that policy reliance on short-rates alone had proved ineffective. It noted

that, in one tightening phase in the early 1950s, higher short rates were followed by higher

long rates only after a long lag. This lag made the eventual movement in long rates

procyclical, rising when the downturn was already beginning. It would have been better to

have directly encouraged the rise in long rates right at the beginning of the tightening

phase.39 Moving all rates up improves the chances of timing countercyclical policy correctly.

The Report explicitly countered the Treasury view on the need to support by bond market by

arguing that greater efforts “to foster greater understanding outside official circles … of the

intentions of the authorities would reduce the risk of perverse reactions in the market [from

bond sales]”.40 How well this advice foreshadows the modern emphasis on effective

communication!

Their recommendation for greater activism in moving long-term rates, however, seems to

have fallen on deaf ears. With government debt around 130% of GDP, it is perhaps not

surprising the authorities were reluctant to countenance any rise in debt servicing costs. In

points out that Paish did not commit himself as to the stability of this relationship (and so not a monetarist in the modern sense of the term).

38 Radcliffe Report (1959), pp 337. 39 Radcliffe Report (1959), pp 174–7. 40 Radcliffe Report (1959), pp 209.

19

any event, the Bank of England in the 1960s had little time for bond sales aimed at driving up

long-term rates.41 What is worse the authorities in later years actually resisted upward

movements in market long-term rates caused by higher inflation or wider budget deficits.

Only the successive crises of the late 1960s and early 1970s put an end to such policy laxity.

Monetary aggregates eventually became the centre of policy. Meeting broad money targets

from the mid-1970s required not only massive increases in short-term rates but also

substantial and regular sales of bonds at higher long-term rates (see Graph 3). A policy of

overfunding budget deficits had the express purpose of driving long-term rates higher. The

yield on consols rose to a peak of 17% (in November 1974), and did not fall to 10% before

the early 1980s.

Whatever the pros and cons of broad versus narrow money to guide monetary policy, the

broad aggregate at least focused official attention on the link between the financing of budget

deficits and financial developments. With a given fiscal deficit, controlling M3 was seen as

practically the dual of a target for the long-term rate on government bonds. Very high nominal

bond yields prompted the government to issue index-linked bonds – a move that successfully

saved the government paying an unjustified (ex post!) inflation risk premium.42 (The

introduction of inflation-linked bonds had also been proposed by the Radcliffe Report but this

too was resisted.)43

Subsequent monetary policy was dominated by a major shift in fiscal policy. Debt

management was progressively reformed. In 1990, HM Treasury explicitly committed itself a

strong “no monetisation” or “full funding” rule for fiscal deficits:

“The authorities will seek to fund the net total of maturing debt, the Public Sector

Borrowing Requirement and any underlying increase in the foreign exchange reserves

by sales of debt outside the banking and building society sectors”.44

41 Capie (2010) notes that the Chief Cashier (Fforde) in 1968 had “little time for Radcliffe-style sales of gilts far

below the market level. To offer new stock at 7½ or 8% yield when the market rate was 7% was complete nonsense.” The words underlined are those of Fforde (pp 471).

42 This innovation was ordered in 1981 by Margaret Thatcher, who was enraged “at the Bank of England’s judgement that the market would require a yield of nearly 16% on conventional 20-year bonds.” See “The lessons from the indexed decade.” Financial Times, 29 April 1991.

43 In 1998, Barro constructed a model showing that issuing inflation-linked bonds would smooth tax rates in the face of GNP cycles. He also argued that persistent inflation shocks would make long-term nominal bonds more volatile than short-term ones. Hence the government would shift to short-term issues as the volatility of inflation rises. Missale takes a similar perspective: see the references in Missale (1999). Tax revenues rise with cyclical increases in income (real and inflation). Short-term interest rates are also procyclical. Hence short-term debt ensures tax revenue and interest payments move together.

44 Enoch and Peters (1992), pp 266.

20

Treasury bills (ie with a maturity of six months or less) were specifically excluded from

counting as funding debt sales. In 1998 responsibility for government debt management was

transferred from the central bank to a Debt Management Office.

United States

McCauley and Ueda (2009) have shown that a similar “bills versus bonds” debate took place

in the United States during the 1930s. The monetarist criticism is that the Federal Reserve

should have countered the depression by buying more Treasury securities (bills or bonds) to

push short-term rates to zero and to provide the banks with excess reserves. The Keynesian

view was taken by the President of the Federal Reserve of New York who argued that

purchasing bonds could “lower long-term rates, increase loans to foreigners and thus

stimulate exports”. As in the United Kingdom, this policy advice was not followed in the

1930s.

Wartime finance followed similar lines as those in the United Kingdom. The Federal

Reserve’s wartime mandate to keep long-term rates low and stable (at 2½% for 25-year

Treasuries) ended only in 1951. In fact, an informal commitment prevailed for many years.

Given a positively sloped yield curve, the objective of lowering interest payments has

generally involved shortening the average maturity of debt or relying on floating-rate debt.

The United States continued to rely to a significant extent on short-term debt for much of the

1950s and 1960s. Only from the mid-1970s, did the US Treasury begin a policy of gradually

increasing the average maturity of debt. By 1980 the average remaining maturity of US

government debt was less than four years (compared with more than 12 years in the United

Kingdom).

The 30-year bond was first issued in 1977 and came to fund a significant proportion of

Federal government borrowing. By the early 1990s, however, the US government was again

arguing that shortening the duration of debt would produce significant savings on interest

costs.45 But the most notable phase of debt duration shortening was between 2000 and 2004

when monetary policy also turned more accommodative.46 In October 2001, the US Treasury

announced it would no longer issue the 30-year bond. This decision was criticised by bond

45 See Campbell (1995). At present, the US Treasury aims to lengthen the maturity of its debt: see United States

Treasury (2010). 46 But there is no evidence for the period 1991 to 2009 as a whole that debt maturity reduction (∆ MAT) was

closely related to changes in the Federal funds rate (∆ R):

∆ MAT = 0.085 + 0.074 ∆ R (1.3) (1.8)

A scatter plot shows that maturity tends to lengthen when the nominal Federal funds rate is rising. But the coefficient on ∆R is not significant at the 5% level. Further research would be useful on this question.

21

market investors because it deprived them of a long-term, risk-free product that was a useful

benchmark for corporate bonds. Against this, it was argued that flight-to-quality

considerations (largely arising in the rest of the world) and dwindling supply had already

undermined the usefulness of Treasury bond yields in providing a benchmark for the pricing

of other securities (Cecchetti, 2000). In any event, the average maturity of Federal

government debt was reduced from 6 years, 2 months to just under 5 years in 2004. 30-year

bonds were then reissued in 2005. By 2009, annual issuance had reached $140 billion, far

greater than in the past (Graph 8).

4. The macroeconomic policy focus of debt managers

Decisions about the management of public debt have a pervasive impact on the economy.47

The mandate assigned to the government debt manager could be defined in a way that

makes it exogenous to macroeconomic and monetary developments.48 The debt manager

could be told, for instance, to ensure that the average duration of outstanding debt should

always be round x years, subject to some (narrow) operational leeway. The efficient markets

view of the world might condone such a mandate: debt management offices could not know

better than the markets.49 They would be told to do this irrespective of the current market

configuration of interest rates.

In practice, however, the debt manager is usually given some discretion to minimise debt

servicing costs in some way. In this case, its actions become endogenous to macroeconomic

and monetary developments. And its discretionary actions would have macroeconomic

consequences.

Debt managers could simply think of minimising average debt costs over a given horizon. If

investing long is a wise investment strategy for a long-term investor (because of the term

premium), then equally issuing short-term debt should in theory save the governments debt

manager this term premium. Indeed, Piga (2001) reports that government do believe they

can reduce the average cost of debt by shortening the duration of their debt. As noted in the

47 The theoretical idea that households can neutralise government borrowing choices (ie saving more when the

government dissaves) depends on strong assumptions that are unlikely to be satisfied. There is a Modigliani-Miller-type argument that the maturity of government debt is of no macroeconomic consequence. It is indeed more plausible to argue that the no-bankruptcy and perfect capital market assumptions (key to the MM result) are more likely to apply to governments than to private corporations. If the government can raise non-distortionary taxes and households have perfect foresight, the Modigliani-Miller theorem in a closed economy is that government debt management policy has no effects on the real economy – if the government can cover the losses it makes on taking the wrong decision by lump-sum taxes on the profits bond holders make from that decision.

48 In recent years, responsibility for debt management has increasingly been assigned to independent managers: the Annex summarises this trend.

49 On this, see Blommestein (2009).

22

Annex, this could be efficiently implemented with interest rate swaps (perhaps maintaining

the appearance of long-dated issuance).

A more complex strategy would be to exploit historical interest rate patterns to decide in a

discretionary way on duration.50 This will not be easy: yields on bonds have shown wide

long-term swings that are not well understood. But some patterns have been detected. For

example, one important – and apparently robust – result quoted by Goodhart (1989) is that:

“With short rates moving down … the long rate on balance has tended to fall when

the yield curve is upwards sloping … so that there are excess returns to be made by

investing long when the yield curve is upwards sloping … the term structure

[completely fails] to predict the future short-term path of interest rates …”.

Conversely, the debt manager in such circumstances should – on this logic – issue short. A

similar reasoning applies if market expectations about inflation or growth adjust too slowly to

deteriorating economic conditions. (Auerbach and Obstfeld (2005) argue along these lines

for central bank purchases of bonds in conditions of a liquidity trap.)

So far nothing has been said of the variance of expanded financing costs. Shortening the

duration of debt in order to minimise the average cost of borrowing could increase the

variability of interest payments in future years. Taking account of the variance of expected

financing costs favours longer-term issuance. The variance of costs depends on the time

horizon chosen. To put the point at its simplest: the variance of expected financing costs is

minimised over a horizon of x years by issuing a bond with a maturity of x years. In addition,

the creditworthiness of the borrower could deteriorate and increase refinancing risks.

Such considerations worry a private sector borrower who cannot count on access to perfect

capital markets in all circumstances. Moral hazard and adverse selection stemming from

information asymmetries mean that even solvent private firms could face greater barriers to

getting credit during a downturn. But governments do not face the same refinancing risks

because of their sovereign power to tax and central banks can issue money.51 As Keynes put

it, a “counter-liquidity preference has more meaning for the private borrower than for the

Exchequer.” Woodford (2000) says that markets – irrespective of the logic of an

intertemporal budget constraint for governments (which is debatable) – treat government

debt differently from private sector debt because government debt “is just a promise to

50 Hoogduin et al (2010) show that, in the euro area, a steepening in the yield curve leads national debt

managers to shorten the duration of their issuance. 51 This is an argument for short-term recourse to taxation or money expansion to forestall a refinancing crisis – it

is NOT an argument about medium-term fiscal choices. In addition, the argument obviously only applies to local currency denominated debt. It would not be true where such sovereign powers are not strong enough to avert the risk of default on foreign currency debt.

23

deliver more of its own liabilities … [cash being] simply government liabilities that happen to

be non-interest-earning.”52 No private firm can do this.

Nevertheless, excessive dependence on short-term debt could have several drawbacks. It

could complicate at least the communication of fiscal policy. It would make government debt

service expenditure more sensitive to changes in short-term rates. In conditions of large

debts to refinance, the budget deficit would thus become more volatile and uncertain – and

this uncertainty could make it difficult for a government to communicate its fiscal strategy.53

This problem would be exacerbated if markets were to see a higher risk of sovereign default

as a result of increased interest rates.54

A second, and related, drawback applies to monetary policy. The prospect of increased debt

servicing costs could lead to government pressure on the central bank not to increase policy

rates. It may even weaken the effectiveness of changes in policy rates as an instrument to

stabilise aggregate demand. This is because higher rates increase the net interest income of

the private sector which holds the bonds. This stimulates private domestic demand but does

not restrain government spending. In extreme circumstances, changes in the policy rate

could have perverse effects, with higher interest rates actually stimulating aggregate

demand. This was an important issue in some industrial countries in the late 1980s and early

1990s.55 Many developing countries have faced a situation of monetary policy having

perverse effects.

Severe or tail-risk adverse shocks could well aggravate these fiscal and monetary

complications. The exceptional shock to global demand in the 2007 financial crisis is one

example. A loss of confidence could lead to a sharp rise in borrowing costs that could require

a huge adjustment to either taxes or non-interest spending. Massive monetary easing would

be required to offset deflationary forces. But it would be hard to know in advance how large

“massive” would be – so the central bank could make a policy mistake. Governments may

wish to avoid such outcomes. (Another, more political, aspect is that the electoral cycle could

lead governments to take short-sighted financing decisions which generate immediate

52 Equally it should be noted that calculations of short-term financing requirements of countries become very

visible in the financial press during times of crisis – suggesting bond investors do focus on how refinancing risks differ from country to country.

53 If debt levels are low, however, there is an argument that an increased dependence on short-term debt could offset cyclical movements in tax revenue – and thus stabilise the budget deficit. See footnote 43 above.

54 In this case, the premium required to hold domestic government debt would rise. Blanchard (2004) points out that in this case, higher policy rates could perversely lead to currency depreciation and higher inflation.

55 Italy faced this situation in the late 1980s. A BIS report of a meeting in 1991 noted that this was a real issue. “Appropriate degrees of monetary tightness might lead to undesirable increases in the budgetary costs of debt service. This could obviously work against budgetary consolidation and fiscal sustainability; in the extreme it might even mean that the net aggregate demand effects of monetary tightening could become perverse.” See BIS (1992).

24

budgetary savings but create longer-term exposures. In some instances, a heavy refinancing

burden could await an incoming government.)

The third, and perhaps decisive, argument applies to financial stability. As Keynes argued,

the government acts as a stabiliser when it adapts to the (shifting) liquidity preference of the

public. Market participants need a risk-free yield curve to manage their own maturity

transformation risks. Pension funds and life insurance companies, for instance, need very

long-term bonds to hedge long-term liabilities. Concentrating issuance at the short end, or

driving long-term rates to near zero, would sacrifice this stabilising function.

These macroeconomic considerations suggest that a long duration portfolio of debt in normal

times is therefore desirable. But this does not weaken the case for adjusting duration in

response to exceptional cyclical developments. Indeed a government with long duration debt

at the onset of a crisis is better placed to conduct countercyclical duration shortening than

one which enters a recession with short duration debt. Exactly as budget surplus in good

times increases the room for fiscal manoeuvre in bad times!

5. Transmission channels56

(i) Long-term interest rate The traditional macroeconomic view is that lowering the average maturity of government debt

has the effect of reducing long-term interest rates facing private borrowers. This works

through the portfolio rebalancing channel – which, as argued above, depends on the

imperfect substitutability of assets of different maturity. It also depends on the willingness of

banks to do interest rate arbitrage. Higher asset prices have wealth effects and, by making

some financial assets more reliable for posting as collateral, may ease borrowing constraints.

The policy entails monetary expansion. Again, these are very old questions. Several

empirical studies conducted before 1960 formulated this issue in terms of the question: how

much must the volume of money increase in order to reduce the bond yield by one

percentage point? A J Brown’s answer in 1939, based on pre-war UK data, was 20%.

A M Khusro’s answer in 1952 was a range of between 10 and 30%. R Turvey’s 1960 study

based on US data found that it took a 10% increase in money to lower the bond yield by one

percentage point.57

56 A reminder: this paper does not seek to address the implications for banks of central bank actions in

short-term interbank markets. 57 As reported in Dow (1965), pp 307, which contains the full references to the papers cited.

25

Lower long-term rates increases asset prices and aggregate demand (Tobin, 1963). But

there has, over the years, been little consensus about the magnitude of these effects. Most

early estimates of term structure equations, for instance, found it hard to detect any

significant impact of changes in the relative supplies of short-term or long-term government

bonds – perhaps because of too little variation in asset supplies.58

Simulations with large scale econometric models, however, suggest that such effects could

be of practical significance. One of the earliest studies is that of Ben Friedman (1992). He

used a combination of the MPS (MIT-Penn-SSRC) quarterly econometric model of the US

and a model representing the determination of interest rates in four separate maturity

submarkets for US government securities. He shows that:

“… a shift to short-term government debt lowers yields on long-term assets … and in

the short run stimulates output and spending … the stimulus being concentrated on

fixed investment.”

The transmission mechanism (in his paper) worked through the corporate bond yield: lower

bond yields stimulated business investment, reduced mortgage interest rates and the

dividend-price yield. He found that a $1 billion shift from long-dated to short-dated debt would

reduce the long-term government bond yield by 55 basis points. This would increase real

residential investment by almost 7% and investment in equipment by 2.5%: real GDP would

rise by 1%. Corporate profits rise by 5%, and equity prices increase by 4%.59 These results

seem high compared with more recent work. Nonetheless they provide a quantification of

Tobin’s earlier theoretical argument that shortening the duration of government debt would

stimulate capital formation and growth.

(ii) Exchange rates60

Domestic official purchases to lower long-term yields should shift portfolio demands from

domestic to foreign assets. The resultant capital flows into higher-yielding foreign assets will

tend to limit the decline in local yields. This should induce currency depreciation, which would

reinforce the impact on aggregate demand noted in (i) above. In a small country with a tightly

58 Some recent studies seem to find significant supply effects: see Krishnamvrthy and Vissing-Jorgensen (2010). 59 See Table 13.1 of Friedman (1992). Note that the assumption about monetary policy in his simulation differs

from recent studies of the impact of Quantitative Easing in the US and the UK: he assumes the growth rate of M1 is fixed so that the Treasury bill rate rises as short-dated paper replaces long-dated paper. The yield curve flattening is therefore larger. The Treasury bill rate rises by 67 basis points. Hence the yield curve flattens by more than a full percentage point.

60 This section does not address the wider issue of the impact of fiscal deficits on the real exchange rate. In the short run a fiscal deficit may lead to real appreciation but a rise in the debt-dependent risk premium suggests real depreciation in the long run. See Kugler (1998).

26

managed exchange rate link to a large country, long-term yields would change little. In the

case of US policies aimed at lowering US yields, Neely (2010) finds evidence that, following

US quantitative easing, yields on non-US bonds also fell by 45 basis points (compared with

the estimated 90 basis points for US Treasuries) and the dollar depreciated by 5%. Hence a

country acting alone gets some additional stimulus from currency depreciation. But if other

countries also adopt more expansionary policies – perhaps in order to limit currency

appreciation – it benefits from increased exports.

Large-scale foreign official purchases of US Treasuries also drive down long-term yields,

reinforcing the impact of the Federal Reserve’s QE. But the impact on the exchange rate

would have the opposite sign – at least to the extent that the alternative for foreign official

purchasers would be increased purchases of non-US debt securities (eg bunds or gilts). The

dollar would tend to appreciate as foreigners buy US bonds. Hence the combined impact of

both foreign official and Federal Reserve purchases of US Treasuries on the exchange of the

dollar is of uncertain sign. Relative magnitudes may provide some guide. At end-2009, the

Federal Reserve held under $800 billion of US Treasuries; the reported direct holdings of

foreign official institutions were $2.7 trillion.

The governments of countries that share a common monetary area (eg the euro area) may

take advantage of their independence in debt management policies to offset their lack of

monetary policy independence. Hoogduin et al (2010) draw attention to a coordination

problem that is specific to the euro area. They find evidence that a steep yield curve prompts

debt managers in individual countries to shorten the maturity of their debts. A government in

a small country might not see this as increasing its own refinancing risks.61 But if several

countries act in this way it does increase refinancing requirements for the euro area as a

whole. This will serve to increase the speed of transmission of shocks in one country

(Greece recently) to other countries seen as sharing similar exposures. They conclude on

“the need for coordination … to limit the use of short-term debt”. This was not covered in the

Maastricht Treaty.

6. More activist debt management policies …

The main conclusion of the last section was that debt management policies could well be

adjusted to serve fiscal, monetary and financial stability objectives. It would be quite wrong to

conclude, a priori, that such adjustments necessarily amount to policy laxity. Fiscal policy

goals could be made more ambitious. Stimulating demand by shortening the maturity of

61 A private corporation would, however, be more cautious about refinancing risks. And investors in government

bonds do worry about refinancing risks.

27

government debt could increase the room for cutting non-interest expenditures. This would

permit a faster reduction in budget deficits. Financial stability policy objectives could also be

furthered. Debt management operations could encourage banks to borrow in capital markets

at longer duration – reducing their exposures to maturity risks. But financial stability could

also be undermined if long-term rates are pushed too low (the Keynes/Tirole arguments,

overvalued asset prices etc).

Altering the long/short mix of government debt issuance on macroeconomic or prudential (as

well as cost-effectiveness) grounds would require significant changes to the rules – on limits,

on timings of changes etc – that govern debt management policies. At present, such policies

in most countries seem to have a narrower, more technical focus – although, as argued

above, they still respond endogenously to macroeconomic developments. How a broader

focus that is attractive in theory would work in practice is difficult to judge. Difficult or not,

governments faced with financing such massive debts will ask this question.

One central empirical question is unresolved: how far would changing the pattern of issuance

(eg increasing short-term portion and lowering the long-term portion) help to flatten yield

curves? It all depends on the strength of portfolio-balancing effects because, as noted above,

short-term and long-term debts are imperfect substitutes. For the reasons discussed above,

substitutability will not be uniform either across countries or over time. The experience of one

country will not necessarily be a good guide to what would happen in another country. What

works in one episode will not necessarily work in another. In times of crisis, in particular,

asset substitutability may well fall (because of greater underlying uncertainty and banks less

able to take interest rate risks) so that stronger price movements could help policymakers.

Policy implications will differ accordingly. If the impact on yield curves is very small, then the

short-run fiscal dividend can be significant because the potential impact on government

interest payments of replacing higher-yield long-dated paper by low-yield short-dated paper

will be large. If the impact on long-term rates is very great, then the government’s action will

be partly self-defeating in that it will shift the yield curve in a direction that limits the impact on

government interest payments.

But a big effect on the yield curve might serve the other public policy purposes. A successful

attempt to bring long-term rates down would stimulate aggregate demand and might help

financial stability. Even the announcement of such a policy could influence market interest

rates by signalling the future financing intentions of the government. This could happen well

before the structure of outstanding debt actually changes very much.

28

… or central bank balance sheet policies

All this of course sounds very like QE by the central bank. Operations in debt markets work

by changing the size or composition of official sector debt held by the private sector. The

purchase of long-term government paper by the central bank which issues short-term debt is

fundamentally equivalent to the government shifting from long-term to short-term issuance.

Internal Treasury/central bank book-keeping operations do not alter this.

Recent studies measuring the impact of QE are summarised in Table 3. The impacts

estimated by various studies seem to vary significantly. Gagnon (2009) notes that recent

empirical studies of the impact of Federal Reserve purchasing of long-term assets produce

estimates of a similar size to earlier studies of comparable changes in Treasury debt

issuance.62 Bean et al (2010) note that UK asset purchases did not affect the expected path

of the Bank of England’s policy rate – hence the primary effects must have been through the

portfolio re-balancing channel (as Tobin, Friedman and others argued in their early analysis)

and not through the signalling of future policy rate intentions.63

What matters is how radically changes in central bank purchases (or Treasury issuance)

alter private sector portfolios. Buying very short-term Treasury securities has little effect

because such paper is a close substitute for money. Buying long-term government debt,

which is less close as a substitute, will disturb private sector portfolios more fundamentally.

Hence the portfolio rebalancing effects will be larger when longer-dated paper is purchased.

Are there any qualifications to the fundamental equivalence of Treasury and central bank

action? Some worry that central bank losses from declines in the market value of

government bonds could weaken the central bank. In principle, central banks need not worry

about a subsequent market value loss of government bonds they purchase because it is

exactly offset by a reduction for the government in the market value of its debt. The net effect

for the official sector as a whole is nil.

Another qualification would be if book-keeping operations were to actually influence

behaviour. It is not difficult to conceive of such circumstances. For instance, central bank

purchases could encourage governments to believe they could finance larger budget deficits.

The market’s judgement of a central bank’s ability to act – and thus its credibility – could be

constrained by its balance sheet. And political economy considerations could be important.

62 He finds that $1 trillion of purchases drives down long-term yields by 39 basis points and that such effects

appear to be long lasting. 63 They cite Joyce et al (2010). They also discuss other UK studies: Meier (2009) finds that the Bank of

England’s ₤125 billion purchase of long-term bonds reduced longer-term bond yields by between 40 and 100 basis points.

29

Ueda (2003) stresses the political constraints on government that are not captured by the

consolidated balance sheet of the central bank and government. Because of the diversity

and complexity of interests which come into play in the government budgetary process, the

Treasury prefers the transfer of a stable stream of profits from the central bank.64

A second qualification is that operations with banks conducted by the central bank and those

with the non-bank public conducted by the Treasury may have different effects. Such

differences, however, depend on how the non-bank public changes its bank balances in

response to Treasury sales.65 If it simply reduces its bank deposits then the effects are

similar as operations vis-à-vis banks. This merits further research, however.

A third qualification, and perhaps of most significance, is that the Treasury/central bank

signalling effects might be different. Central bank action sends a signal about future policy

rates. Much recent research has focused on this. But debt management decisions also send

a signal about the nature of future Treasury financing. Both could trigger powerful

expectation effects. But there may be another difference in signalling. The financial press

may give inordinate coverage to central bank actions (as with the Federal Reserve’s QE in

November 2010) – but overlook the equally important but less visible actions of debt

management offices.

Which institution should take the lead in activist debt management policies?66 The case for

the central bank doing so is that such operations have effects that are similar to those of

monetary policy. Quick decision-taking is essential to ensure correct timing with respect to

the cycle – otherwise such measures could be destabilising. This also suggests the central

bank. A central bank’s technical capacity in market operations points to a similar conclusion.

Indeed, Goodhart (2010) argued that a review of central banking through the years suggests

that the essence of a central bank is not setting official rates. It is instead its ability to lend via

open market operations. Exactly which assets it should buy and sell is controversial and has

in practice changed radically over time.

The case against the central bank taking the lead is that the independence of monetary

policy could be undermined by perceptions that the central bank is supporting the price of

64 Ueda (2003) writes: “The single year budgeting principle and the diversity and complexity of interests within

the government give rise to huge inter- and intra-ministry negotiation costs when reshuffling is required between different categories of expenditure and revenue … Compensating for any shortfall [in transfers from the central bank] with other revenue items would inevitably entail adjustment costs … More seriously, the government may take advantage of the opportunity of capital injection to the central bank to influence monetary policy.” Klüh and Stella (2008) provide cross-country evidence that a strong central bank balance sheet helps the achievement of lower inflation.

65 See Congdon (2010) and Box 1 in McCauley and Ueda (2009). 66 It is interesting that Milton Friedman, in commenting on an earlier version of Congdon (2010), did not say this

was a fiscal responsibility, but instead said that the central bank could perform such operations.

30

government debt. A second argument is that debt management choices can have

distributional consequences – and so are the responsibility of an elected government. (But

monetary policy also has distributional consequences.) Whether activist debt management

policies make a profit or a loss should not influence the allocation of responsibility because

any capital gain the central bank earns from QE can be transferred to the government.

It was noted above that, when debt management practices were constrained by benchmarks,

rules could be devised to alleviate the problem of coordination with monetary policies. But

activism in both debt management policies by the Treasury (or DMO) and central bank

balance sheet policies would create coordination problems. A central bank could not take

optimal decisions in response to macroeconomic developments if it did not take account of

how the Treasury would respond. It would also pose a major governance issue about

responsibilities and accountabilities. As Truman (2005) has argued, the two agencies

managing a common balance sheet must work closely together.

On this logic, cooperation between the central bank and the Treasury should not be

constrained by rather arbitrary rules of thumb.67 The debate turns on the practical question

whether such rules, given political or institutional constraints, could serve to forestall short-

sighted policies that weaken accountability mechanisms that hold specific institutions to their

mandates. This important practical question is beyond the scope of this paper.

Without coordination, QE operations decided by the central banks could well be contradicted

by Treasury financing decisions. According to a report issued in August 2010, however, the

US Treasury has been lengthening the average maturity of its outstanding debt (after steady

declines from 2002 to 2007) – which is difficult to square with the objectives of QE.68 When

the Federal Reserve used open market operations to flatten the yield curve by shortening the

average maturity of Treasury debt in the 1960s (Operation Twist), the US Treasury in effect

worked against this policy by lengthening the maturity of issuance.

Both the adoption of, and exit from, QE would require coordination with the Treasury. If the

aim is to stimulate aggregate demand, government debt management policies should not

cancel out the effect of QE operations. If the aim is to adjust the central bank’s balance sheet

67 His trenchant words, pre-dating recent central bank balance sheet activism, are worth quoting: “The

proposition that a central bank should limit its purchases of long-dated government debt because not to do so would impair its balance sheet and de facto independence [is incorrect] … as long as the central bank purchases long-dated government obligations in the open market, and has no obligation to roll them over, the central bank should have no legislated or self-imposed limit on the amount of such obligations it may purchase.” But see the counterargument of Ueda (2003), cited in footnote 64 above.

68 See US Treasury (2010a). See Friedman (1992). Congdon (2010) argues that the Japanese Ministry of Finance also continued to sell vast quantities of long-dated paper during the quantitative easing period 2001 to 2005. See also McCauley and Ueda (2009).

31

without weakening aggregate demand (eg as might be the case for exit from QE), then debt

management policies could well offset central bank sales or purchases of government bonds.

It is therefore essential to examine recent QE in conjunction with government debt

management policies. Some historical perspective is also illuminating. Because measures

recently adopted have taken so many diverse forms (reflecting the specific features of this

crisis), it is not possible to do this with any precision. Nevertheless, updating the first table in

Tobin’s 1963 paper – which summarised the structure of Federal government debt in the

hands of the public – provides an illuminating bird’s-eye view. See Table 4. At the end of

World War II, US government debt was mainly long-term: in 1945, the mean maturity of the

marketable debt was just short of 10 years. But for the 30 years following the war, the US

Treasury relied on short-term borrowing. In 1955, 45% of the debt was financed by currency,

central bank obligations and short-term government debt – often dubbed “monetary

financing”.69 By the end of the 1960s, monetary financing has risen to 65%. From 1976 until

1990, however, greater reliance began to be put on issuing long-term debt.70

With the adoption of QE after the crisis, however, reliance on short-term debt and Federal

Reserve obligations has been increased. Between the end of FY2007 and the end of

FY2009, currency and Federal Reserve obligations rose by $946 billion; short-term

marketable securities outstanding increased by about $1,031 billion. This clearly represents

a very significant easing of policy. The degree of monetary financing went from 34% to

42.9%. But note that the degree of monetary financing – as measured in these simplistic

terms – is much less than in 1969. The longer duration of debt at the beginning of the crisis

gave the authorities greater scope to pursue an ambitious QE policy. In addition, the

calculation suggests that the degree of monetary financing declined from 42.9% at

end-September 2009 and to 35.8% at end-September 2010. This reflects an underlying shift

in Treasury issuance away from short-term paper and towards long-dated paper.

On 3 November 2010, the Federal Reserve announced a special programme to buy between

$850 and $900 billion longer-term Treasury securities. The announcement was remarkable

for the detail provided to the markets in the interest of transparency: see Box 2. This number

sounds very large. It is, however, not possible to assess the impact of this without

considering changes in Treasury issuance policy. This is not straightforward. There is a wide

69 Hoogduin et al (2010), for instance, describe the case of the Netherlands: “In the 1980s, government debt

finance was an explicit part of the monetary analysis of De Nederlandsche Bank … when the government financed part of its debt in the money market, it was considered monetary financing, which would increase the amount of liquidity in the economy.”

70 The post-war minimum in average maturity was reached in January 1976 when it reached just 28 months. See Friedman (1992) pp 111–2.

32

array of maturities (not just short versus long) and this makes it difficult to construct a

detailed consolidation of central bank and Treasury balance sheets.

Box 2 QE 2 by the Federal Reserve

The FRBNY announced on 3 November that it expects to purchase $850 to $900 billion of longer-term Treasury securities before the end of June 2011. It expects that the assets purchased will have an average duration of five to six years. The 35% limit on Federal Reserve holding of specific issues, under which the Open Market Trading Desk had been operating, would be relaxed.

The press announcement said that the Desk plans to distribute purchases across maturity ranges according to the approximate weights below:

5%: 1½ - 2½ years

20%: 2½ - 4 years

20%: 4 - 5½ years

23%: 5½ - 7 years

23%: 7 - 10 years

2%: 10 - 17 years

4%: 17 - 30 years

3%: TIPS

Purchasing mechanisms were spelt out in a very transparent way. The results of each operation will be published on the FRBNY’s website shortly after each purchase operation has concluded. The Desk will also begin to publish information on the prices paid in individual operations at the end of each monthly calendar period, coinciding with the release of the next period's schedule.

From September 2007 to September 2008, US Treasury bills held by the public had risen

from $1.2 trillion to $2 trillion – a significant monetary expansion. The average duration of

debt fell from 4 years 10 months to just over 4 years. But from mid-2009, debt issuance

policy changed in a restrictive direction. Short-dated bills declined and long-dated bonds

expanded, with the average duration of total marketable debt rising to almost 5 years

(Table 5). Bonds in the hands of the public rose from $4.6 trillion at end-June 2009 to

$6.7 trillion at end-September 2010. The percentage of US Treasury debt maturing in the

next 12- and 24-month periods has fallen to historic lows. The $850–900 billion Federal

Reserve purchases has to be considered in this context. It must be measured against the

composition of the expansion in Treasury bond issuance (and of bill issuance) over the

period up to June 2011 needed to finance a large budget deficit. At present, this is unknown.

However, the minutes of the latest meeting of the Treasury Borrowing Advisory Committee

(which met on 2 November 2010) noted:

“Overall, the Committee was comfortable with continuing to extend the average

maturity of the debt … The question arose regarding whether the Fed and the

Treasury were working at cross purposes … It was pointed out by members of the

Committee that the Fed and the Treasury are independent institutions, with two

33

different mandates that might sometimes appear to be in conflict. Members agreed

that Treasury should adhere to its mandate of assuring the lowest cost of borrowing

over time, regardless of the Fed's monetary policy. A couple members noted that

the Fed was essentially a "large investor" in Treasuries and that the Fed's behavior

was probably transitory. As a result, Treasury should not modify its regular and

predictable issuance paradigm to accommodate a single large investor.”71

Almost all recent press commentary on QE ignores this critical point about the need to take

account of Treasury issuance policy. A temporary change to the yield curve induced by

central bank action may lead the debt manager to alter its issuance policy to take advantage

of what it might view as a temporary interest rate “distortion”. Ironically, part of the discussion

in the Treasury Committee centred on whether further shrinkage of bills issuance, at a time

when private issuance of short-term debt securities had declined, could lead to difficulties of

market functioning.

7. Conclusion

Public sector debts in the advanced countries are going to be very large for several years.

This could have big implications for how central banks set monetary policy. The issue is not

fiscal dominance in the simplistic sense of “inflating away the debt”. But there is a more

subtle dominance that comes from increased uncertainty about the equilibrium long-term

interest rate on government debt.

Economists do not agree on the magnitude of the impact of structural budget deficits on

long-term interest rates. In addition, there is an important political issue. The desire to save

debt servicing costs is likely to prompt a major re-examination of policy frameworks that

guide government debt management policies. More activist debt management policies aimed

at keeping long-term interest rates low during a period of weak or uncertain growth could well

be warranted on macroeconomic grounds. Indeed, Keynes argued strongly for such policies

at the start of the 1930s.

Economists throughout the post-war period have periodically argued for lengthening the

duration of bonds in the hands of the public (ie not the central bank) in order to raise

long-term rates to combat inflation. The Radcliffe Report was quite explicit that the central

bank should push up the whole yield curve when it wanted to tighten monetary policy. Tobin

argued in the 1960s that shortening the maturity of government debt would increase private

71 See US Treasury (2010b).

34

capital formation, a result confirmed by Ben Friedman’s simulations in the early 1990s.

Combining fiscal consolidation with significant reductions in the duration of government debt

may well be an attractive strategy for governments struggling to reduce large budget deficits

without killing the private capital formation on which future growth prospects depend.

The case for central bank transactions in long-term debt markets, rather than an acting only

in the short-term bills market, is that a rise in investor uncertainty about the path of future

short-term rates will reduce the substitutability between short-dated and long-dated paper. In

such circumstances, central banks may more efficiently guide markets if they act across the

maturity spectrum. This case for such action, which is broader than the special case of the

ZLB, applies symmetrically to monetary restriction and to monetary expansion.

Central banks will also have to weigh the consequences for financial stability. A policy

orientation aimed at keeping long-term interest rates low for a prolonged period of time is

going to increase aggregate interest rate risks in the financial industry. How to analyse the

financial stability risks that such exposures entail is unclear. But such exposures seem likely

to have financial stability consequences that will directly impinge on the new, broader

mandate of central banks. In theory, it is possible that central banks can adjust regulatory

policies (“macroprudential”) that limit the maturity exposures that low interest rates

encourage. In practice, however, regulatory action partly geared to macroeconomic

conditions will be difficult to calibrate and to implement – and may even weaken the

responsibility of financial firms for managing their own exposures.

By putting balance sheet policies at the centre of their operations in the current

low-interest-rate environment, many central banks – not all of course – have implicitly

accepted the logic of Keynes’s position. The recent evidence suggests that balance-sheet-

augmented monetary policy has been effective. But most studies fail to take account of

changes to government debt management policies which are equivalent to central bank

transactions in government debt. In addition, there are reasons for thinking that the size of

such effects, depending as they do on the cyclically sensitive degree of asset substitutability,

are likely to be unpredictable. In addition, an upward sloping yield curve can increase the

banking system’s demand for government bonds – but this effect, highly dependent on

expectations, is also hard to predict.

The appetite of large forex reserves holders in Asia and other EMEs for low-risk dollar debt

has also put downward pressure on long-term yields. This heavy weight of official investors

may also have reduced the price sensitivity of the demand for such bonds in the short run.72

72 Noting that foreign official bodies are the registered holders of almost 40% of US Treasuries, Krishnamurthy

and Vissing-Jorgensen (2010) find evidence that official investors are less price sensitive than private

35

Because many central banks accumulating reserves have not followed strict “no

monetisation” rules (cf the UK Treasury’s full funding rule cited above), this intervention has

entailed monetary expansion. The controversy concerns just how much monetary expansion

reserves accumulation has entailed since there is no widely agreed way of measuring

“monetisation”. In addition, low long-term rates at the centre of international monetary system

in turn influence the pricing of debt (and asset prices generally) in the EMEs, leading to local

policy reactions.

Measuring the joint impact of these two, quite distinct policy orientations is, for all these

reasons, impossible. Hervé Hannoun (2009) suggests, as a rough-and-ready calculation,

adding central bank assets in advanced economies (panel A in Graph 9) to foreign exchange

reserves of the major EMEs (panel B). On this calculation, what he terms “global official

liquidity” has risen from about $7 trillion in mid-2007 to around $12 trillion by mid-2010.73

Official support on this scale is not sustainable. The intention of central banks in the

advanced economies to shrink their balance sheets to more normal levels once

circumstances permit has been well advertised.

Yet the reassuring argument that only once-in-a-century circumstances led central banks to

such policies is unconvincing. Monetary history is full of periods when investors become

unusually uncertain about the path of future short-term rates. A very large rise in government

debt accentuates such uncertainty. Financial stability considerations point to the same

conclusion: the sizeable interest rate exposures of systemically important financial

intermediaries may also be used as an argument for resisting sudden upward movements in

the long-term interest rate during the exit from QE – so that central banks may

simultaneously be raising the policy rate and yet still be active in supporting the market for

government bonds. Even when the current policies have been reversed, future periods of

macroeconomic weakness may well lead to pressure for their reinstatement.

Balance-sheet-augmented monetary policy once billed as exceptional may instead come to

define a new starting point … or, to be more accurate, to return to some earlier paradigms of

monetary policy.

There is, therefore, a need to develop a policy framework for official actions motivated by

macroeconomic considerations that affect the maturity structure of government debt. Without

such a framework, even rational policies that economic theory suggests will work may just

investors. However, foreign official holders did move from short-term bills to 10-year Treasuries as short rates fell from September 2008.

73 Hannoun warns strongly against a “new permanent accommodative monetary policy regime in which central banks would be able and willing to control the entire length of yield curves as well as credit spreads and mortgages rates”.

36

deepen uncertainty. Markets need to understand what governments or central banks are

trying to do.74

How should the objectives of such policies be formulated? The target could be specified in

terms of quantities or of prices. Operations could be spread across the maturity spectrum (to

minimise distortions along the yield curve) or could focus on specific maturities. Operations

could concentrate on medium-term paper (so that the bonds automatically run off the central

bank’s balance sheet earlier) or very long-term paper. It might be necessary to indicate in

some way the conditions that would trigger the adoption (and the reversal) of such policies.

The “real intention” of policy may be quite complex, and a central bank might find itself

having to communicate simple if not fully accurate messages. Should such policies be

symmetric, to be used to achieve or to accelerate macroeconomic policy tightening as well

as easing? Historically there has been strong official resistance to central banks selling

bonds when governments have heavy debts to refinance: governments often want to keep

debt service costs down at all costs. What is the division of responsibility between the Debt

Management Office (or Treasury) and the central bank? Should Debt Management Offices

be more transparent, for example revealing how changes in their derivatives positions have

altered their interest rate exposures? It is not difficult to think of many other questions. The

problem with all policy innovations (particularly those decided in the heat of a crisis) is that

they can create additional uncertainty for the private sector.

The lack of a well-articulated policy framework could be particularly dangerous if very large

structural budget deficits were to weaken the policy credibility of governments and central

banks on all fronts. Long-term rates are all dependent on expectations – about future fiscal

deficits and debt levels, about their financing and about the anti-inflation commitment/efficacy

of monetary policy. Greater and asymmetric activism to address immediate difficulties could

ultimately destabilise countries with weak macroeconomic credibility (fundamentals or

history). When monetary tightening is needed to resist inflationary pressures, central banks

may in some circumstances wish to reinforce increases in the policy rate with sales of

government bonds so that long-term rates also rise. Deciding on the volume and the timing

of such sales will be difficult. Coordination with government debt management policies that

are not in the hands of the central bank will create challenges not only in the implementation

but also in the communication of policies affecting the consolidated balance sheet of

government and central bank.

74 Blommestein et al (2010) note that discussions in April 2010 at the OECD-WBG-IMF’s Global Bond Market

Forum underlined the importance in current circumstances of massive government bond issuance of “managing investor uncertainty”.

37

This paper has tried to show that this issue is in fact a very old and controversial one that

economists and policymakers have grappled with for years. It is an intricate issue that has

multiple ramifications. It calls into question three widely-held assumptions about economic

policy listed at the beginning of the paper. There are no simple answers. Such complications

could perhaps be ignored when fiscal positions were stronger. But when government

debt/GDP ratios are very high, they cannot be ignored. To answer the question of this

Symposium, a useful central bank will be one that addresses these complexities.

38

Annex

Responsibilities for government debt management

Until the mid-1990s, it was central banks which generally had responsibility for managing the

day-to-day operations in government debt securities. There were very good rationales for

this. Their daily operations in financial markets normally give central banks deeper market

intelligence than Treasuries. Government debt operations affect money market conditions in

which central banks operate for monetary policy purposes. These operations also influence

the balance sheets of banks, and thus can affect changes in aggregate credit, another

traditional focus of central bank monetary policy.75

The problem of course is that any mandate for keeping yields down (or limiting volatility) can

conflict with the monetary policy need to adjust interest rates in the light of changing

economic conditions. Even if the central bank resists such a temptation, market perceptions

of such a conflict could affect inflation expectations. Another conflict of interest is that

advanced knowledge of its interest rate decisions could induce a central bank to bring

forward bond issuance ahead of raising interest rates. For this reason, the market may “read”

future monetary policy decisions from debt issuance practices. To avoid such conflicts, the

central bank responsibility for managing day-to-day operations were often subject to certain

limitations.76 But these often became theoretical when very large budget deficits had to be

financed.

The authorities have over the years applied various rules of thumb to transactions or balance

sheets to delineate the responsibility of the central bank from other various government

agents. Examples of such rules of thumb include: ceilings to central bank holdings or even

limits to transactions in government bonds;77 rules to limit government issuance of short-term

paper.

75 A related issue, not the subject of this paper, concerns foreign exchange reserves. In many EMEs in recent

years, central banks have come to manage larger and larger portfolios of foreign assets. In some cases, other bodies were responsible for managing foreign liabilities, giving rise to coordination issues.

76 The Chief Cashier at the Bank of England (Kenneth Peppiatt) in 1952 put the classic central bank case. He explained how its actions in the government bond market, confined to the short-term smoothing of technical difficulties, did not attempt to stabilise the market. “As the Central Bank we have a duty to control the volume of credit … but no such duty to control the price of Government securities. It would be difficult … to achieve both objectives at the same time because, when we are restricting credit, securities tend to fall … and if we were to seek to reverse this movement by pumping large sums of money into the market, [we would] defeat our primary purpose.” See Fforde (1992), pp 648–49. Capie (2010) notes the irony that the excessive official intervention in the government bond market from the late 1950s, which Fforde criticised in his Bank of England history, “reached its peak in the late 1960s when Fforde himself was Chief Cashier.”

77 Inoue (2010) cites the Bank of Japan’s “Banknote Rule” (the rule that stocks of JGBs were not to exceed the outstanding amount of bank notes). McCauley (2008) cites Ritter (1980), which recounts the “bills only” view of the Federal Reserve Board in Washington (opposed by the Federal Reserve Board of New York), which

39

In the late 1980s and early 1990s, a growing appreciation of the dangers of policy confusion

created by unclear mandates led to an international consensus that government debt

management policy deserved specific attention in its own right. The debt management

function in many countries was made less discretionary. Clear objectives were designed

(usually to minimise expected costs subject to pre-defined risk tolerance limits). Issuance

calendars were pre-announced. There was the widespread adoption of portfolio benchmarks,

often supported by mechanisms to hold portfolio managers accountable and to allow external

managers to compete with in-house managers. This was often associated with the objective

of lengthening the maturity of government debt.

Predictable policy frameworks were seen as important because they helped to stabilise

expectations. The whole process was put on a firmer empirical footing.78 In many countries,

this realignment of policy frameworks went together with the independence of central banks

with clear inflation mandates. And the operational responsibility of managing government

debt was in several countries removed from the central bank. Many countries established

independent Debt Management Offices that were often required to report directly to

Parliament (not the Treasury). Few seem to have established standing committees to

formally coordinate Treasury, central bank or debt office policies.

Reforms also meant that the staff in specialised debt management offices often have greater

financial market expertise than those who managed government debt in earlier decades. The

use by many debt managers (but not those of the United States) of derivatives has grown. It

has become so widespread that a recent undergraduate textbook on money and banks

explains how government debt managers use interest rate swaps.79 They issue long-term

debt for pension funds etc to hold but then swap the stream of interest payments due for the

(lower) interest payments they would have paid had they issued short-term debt.

Piga (2001) provides an excellent analysis of how government debt managers have used

derivatives. It is cheaper to take speculative positions in swaps than in cash markets, and

some governments have used swaps to benefit from expected movements in exchange rate

and interest rates (ie speculation, not hedging). Swaps can also be used to defer interest

payments to future years so that the current budget deficit can be understated. (Piga

analyses a particular instance in some depth.) Derivatives can in short make both

government debt exposures and budget balances more opaque.

argued for concentrating operations on short-term government securities and so limited operations in the bond market.

78 An excellent account of this progress is Wheeler (2004). See also OECD (2005). BIS (2000) examines changes in policies in the emerging market economies.

79 Cecchetti and Schoenholtz (2011), pp 221–2.

40

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44

Graphs and tables

Graph 1 The many sides of fiscal dominance

Graph 2 The real long-term interest rate

Graph 3 Government debt and interest rates in the UK

Graph 4 Bond yields and swaption-implied volatility

Graph 5 Dollar term spread and interest rate carry-to-risk ratio

Graph 6 Indicators of long- and short-term funding costs

Graph 7 Global issuance of syndicated debt securities by banks

Graph 8 30-year US Treasury bonds

Graph 9 Global official liquidity

Table 1 Debt securities outstanding

Table 2 Debt securities, changes in stocks

Table 3 Estimates of recent quantitative easing in the UK and US

Table 4 Composition of marketable US Federal government debt held by the public

Table 5 US Treasury securities held by the public

45

Graph 1

The many sides of fiscal dominance

Monetary policy

Financial stabilitypolicy

Debtmanagement

policy

Large government

debt

Monetary policy

Financial stabilitypolicy

Debtmanagement

policy

Large government

debt

46

Graph 2

The real long-term interest rate1

In per cent

0

1

2

3

4

5

6

80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10

United KingdomSimple average of Australia, France, United Kingdom and United States

1 10-year inflation-indexed yields; for Australia, 20-year; for the United Kingdom, constructed from long-term inflation-linked bonds issued since 1996.

Sources: National data; BIS calculations.

47

Graph 3

Government debt and interest rates in the UK

A. Fiscal indicators

As a percentage of GDP

0

1

2

3

4

5

0

50

100

150

200

250

1940 1950 1960 1970 1980 1990 2000 2010 2020

General government gross debt (RHS)1

Interest payments on public net borrowing (LHS)2

1 On a Maastricht treaty basis; March 2010 HMT Budget forecasts. 2 March 2010 HMT Budget forecasts.

Sources: HM Treasury (HMT); B Mitchell, British historical statistics; Cambridge University Press; OECD; UK Office for National Statistics; Economic Trends Annual Supplement; national data.

B. Nominal GDP growth1

In per cent

–10

0

10

20

1940 1950 1960 1970 1980 1990 2000 2010 2020

Real GDP growthAnnual inflation rate

1 After 2009, March 2010 HMT Budget forecasts.

Sources: HM Treasury (HMT); B Mitchell, British historical statistics; Cambridge University Press; UK Office for National Statistics; national data.

C. Gross interest yield on 2.5% consol

In per cent

0

5

10

15

1940 1950 1960 1970 1980 1990 2000 2010 2020

Source: B Mitchell, British historical statistics; Economic Trends Annual Supplement; Datastream.

48

Graph 4

Bond yields and swaption implied volatility

Japan: 2002 - 2005

0

40

80

120

160

0

1

2

3

2002 2003 2004 2005

Bond yields (rhs)1

Implied volatility (lhs)2

United States: 2008 - ???

0

40

80

120

160

1

2

3

4

2008 2009 2010 2011

1 Ten-year government bonds; in per cent.

2 Implied swaptions, in annualised basis points.

Sources: Bloomberg (Deutsche Bank ticker DVX and DVXCJPY); national data.

49

Graph 5

Dollar term spread and interest rate carry-to-risk ratio

Term spread1

–100

0

100

200

300

400

500

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Carry-to-risk ratio2

–1

0

1

2

3

4

5

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

1 Ten-year swap rate minus three-month money market rate, in basis points. 2 Defined as the differential between 10-year swap rate and three-month money market rate divided by the three-month/10-year swaption implied volatility.

Sources: Bloomberg; BIS calculations.

50

Graph 6

Indicators of long- and short-term funding costs

In per cent

Bank bond and government bond yields1

1.5

3.0

4.5

6.0

7.5

9.0

2006 2007 2008 2009 2010

BankGovernment

Policy and interbank rates2

0

1

2

3

4

5

6

2006 2007 2008 2009 2010

Policy rate3-month Libor

1 Simple average of bonds with remaining maturity of 7 to 9 years for the United States and 4 to 6 years for the euro area; forgovernment bonds, 10-year. 2 Simple average of the euro area and the United States.

Sources: Bloomberg; Merrill Lynch; national data.

51

Graph 7

Global issuance of syndicated debt securities by banks1

In billions of US dollars

0

20

40

60

80

0

800

1,600

2,400

3,200

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Guaranteed issues (rhs)Other issues (rhs)% guaranteed (lhs)

1 Announced issuance placed in domestic and international markets; by ultimate sector; excluding preferred shares, ABS, MBS and covered issues. For 2010, January to September data.

Sources: Dealogic; BIS.

52

Graph 8

30-year US Treasury bonds

A. Spread over 10-year US Treasuries

In basis points

–100

–50

0

50

100

150

200

76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10

B. Issuance1

In billions of US dollars

0

25

50

75

100

125

150

76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10

1 Remaining maturity of about 30 years at end-December. Only marketable bonds issued between January and December of aparticular year are used for that particular year’s debt issuance calculation. 2010 figure includes issuance up to end-October.

Sources: Treasury Direct; national data; BIS calculations.

53

Graph 9

Global official liquidity

In trillions of US dollars

A. Central bank assets in advanced economies1

3

4

5

6

7

8

2006 2007 2008 2009 2010

B. Foreign reserves of major EMEs2

1

2

3

4

5

6

2006 2007 2008 2009 2010

C. Global official liquidity (A + B)

4

6

8

10

12

14

2006 2007 2008 2009 2010

1 Total for the United States, the euro area, Japan, Canada, Sweden, Switzerland and the United Kingdom. 2 Total of major emerging market economies (Brazil, China, Chinese Taipei, Hong Kong SAR, India, Korea, Malaysia, Mexico, Russia, Singapore, Thailand andTurkey).

Sources: Datastream; national data.

54

Table 1

Debt securities outstanding1

In billions of US dollars

Dec 89 Dec 99 Dec 06 Dec 09 June 10

Governments 7,201 14,407 25,444 36,403 37,584

United States 2,839 4,408 6,236 9,479 10,338

Japan 1,306 3,670 6,750 9,657 10,538

Germany 250 622 1,479 1,850 1,651

Other euro area 1,474 2,832 4,796 6,715 6,033

United Kingdom 226 473 841 1,239 1,300

Financial institutions 5,873 15,550 34,654 44,109 40,906

United States 2,656 7,979 16,014 17,464 16,687

Japan 928 1,662 1,079 1,204 1,237

Germany 482 1,531 2,399 2,649 2,242

Other euro area 959 1,898 7,720 12,124 10,669

United Kingdom 151 712 2,604 3,763 3,444

1 Domestic plus international.

Note: The BIS endeavours to eliminate any overlap between its international and domestic debt securities statistics as far as possible. However, as two different collection systems are used (security by security collection system for IDS and collection of aggregated data for DDS) as well as two different approaches and definitions (market definitions for the IDS and statistical definitions in the DDS), some overlap and inconsistencies might remain by a margin which differs from country to country.

Source: Dealogic; Euroclear; Thomson Reuters; Xtrakter Ltd; national authorities; BIS.

55

Table 2

Debt securities, changes in stocks1

In billions of US dollars

2003–20062

2007 2008 2009 June 20102

Governments 1,771 1,195 2,651 4,226 4,745

remaining maturity < 1 year 346 –52 1,500 318 416

longer remaining maturity 1,425 1,247 1,150 3,908 4,329

Financial institutions 3,084 4,928 2,602 520 –1,187

remaining maturity < 1 year 588 808 –56 –902 –523

longer remaining maturity 2,497 4,120 2,658 1,422 –664

World GDP 43,479 55,392 61,221 57,937 59,8591 Domestic plus international issues. Exchange rate adjusted. ² Annualised.

Note: The BIS endeavours to eliminate any overlap between its international and domestic debt securities statistics as far as possible. However, as two different collection systems are used (security by security collection system for IDS and collection of aggregated data for DDS) as well as two different approaches and definitions (market definitions for the IDS and statistical definitions in the DDS), some overlap and inconsistencies might remain by a margin which differs from country to country.

Source: Dealogic; Euroclear; Thomson Reuters; Xtrakter Ltd; national authorities; IMF; BIS.

56

Table 3

Estimates of recent quantitative easing in the UK and US

Impact on

Long-term rates

Exchange rate (or foreign impact)

United States

Prakken (2010) 50 bp fall in 10-year bond yield lowers the dollar by 2%

Neely (2010) US 10-year Treasury yields fell by a total of 107bp during the 5 Large-Scale Asset Purchase buy windows ($1.75 trillion dollar total debt purchase)

Foreign 10-year government bond yields (Australia, Canada, Germany, Japan, UK) fell by a total of on average 53bp during the 5 Large-Scale Asset Purchase buy windows

The US dollar exchange rate against the AUD, CAD, EUR, JPY, £ depreciated by a total of on average 6.6% during the 5 Large-Scale Asset Purchase buy windows

Gagnon et al (2010) US Large-Scale Asset Purchases ($1.75 trillion dollar total debt purchase) lowered 10-year Treasury yield by 90 bp

D’Amico and King (2010)

US purchase of $300 billion of US Treasury coupon securities lowered 10 to 15 Treasury yields by up to 50bp

Meyer and Bomfim (2010)

Fed communication about Large-Scale Asset Purchases ($1.75 trillion dollar total debt purchase) reduced 10-year Treasury yield by 50 to 60 bp

United Kingdom

Meier (2009) £125 billion purchases reduce longer-term gilt yields by between 40 and 100 bp

Joyce et al (2010) Total impact of £200 billion of purchases (most of which gilts) lowered long-term gilt yields on average by 100 bp, with reactions ranging between 55 and 120 bp across the 5-25 year segment of the yield curve

Sterling ERI depreciated by 4%

57

Table 4

Composition of marketable US Federal government debt held by the public

$ billion

Marketable securities

(<or = 1 year) (> 1 year)

Currency & Federal Reserve

obligations

Total Money, Federal

Reserve obligations and short-term debt

End of fiscal year

(Sept)

(a) (b) (c) (d) = (a+c) % d

1955 43 113 51 207 45%

1969 80 82 73 235 65%

1990 527 1668 306 2501 33.3%

2001 735 2180 638 3553 38.6%

2007 955 3474 834 5263 34%

2008 1484 3726 1087 6297 40.8%

2009 1986 5002 1780 8768 42.9%

20101 1784 6692 1943 10419 35.8% 1 Using Monthly Statement of the Public Debt of the United States; Federal Reserve Table H.4.1.

Sources: This is an update of that in Tobin (1963) using US Treasury Bulletin; Federal Reserve Flow-of-Funds.

58

Table 5

US Treasury securities held by the public

$ billion

Total Bills Bonds2 Memorandum:

average residual maturity

20091

June 6592 2000 4592 3 years 11 months

August 6918 2062 4850 4 years 0 months

Dec 7250 1788 5462 4 years 4 months

2010

June 8079 1777 6302 4 years 7 months

Sept 8476 1784 6692 4 years 11 months 1 End of month. 2 Notes, bonds and TIPS.

Sources: US Treasury Bulletin and Treasury Borrowing Advisory Committee.